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Sri Lanka’s finance companies pushed into riskier business: ex-banker

Feb 10, 2014 (LBO) - Sri Lanka's finance companies, non-bank lenders that lent to riskier clients were taking on more risk due to structural changes in the financial sector, a veteran banker said. Ranjith Fernando, former head of National Development Bank said finance companies served an important function in the economy by catering to customers who would otherwise not have got bank financing.

Risk Reward

They also paid higher interest rates to people who were willing to take the risk.

"It depends on the risk appetite the person has," Fernando told a seminar organized by Consultants 21, an organization connected to Nihal Sri Amarasekera, a public interest activist.

"People who are not happy with the 8 percent or 6 percent return on deposit in a commercial bank who want to more, and who are prepared not to go to a Bank of Ceylon or HSBC, but go to a finance company because they pay 12 or 15 percent.

When inflation was high there was a greater tendency to go for higher interest rates, he said.

The finance companies in turn financed customers who were not served by banks at a rate higher than a bank loan.

"So within the financial sector the risk return trade-off is where there is a need for financial sector institutions to cater to the risk profile of people who bank with them," Fernando said.

"So there are products and institutions in the whole financial sector that catered to them."

Finance companies also gave credit faster with less hassle and documentation, sometimes within one day.

Fernando said many start-ups started with a lease from a finance company and later became big business groups. Non-bank lenders therefore served and important function in broadening access to credit and economic growth, he said.
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Analysts say all savers and investors should follow some basic steps by splitting and investing in a variety of institutions (not putting all the eggs in one basket) to avoid their savings from being wiped out by the failure of one institution.

As a person gets older their ability to recover from losses is reduced and their exposure to high-risk-high-return products like finance companies should also be cut in favour of lower risk products like larger banks, and treasury bills.

A saver can use credit ratings to gauge the risk. Within the finance company sector also some companies have investments grade ratings from around 'BBB-' upwards going into levels such as AA.

Structural Changes

Fernando said in recent years, structural changes in the financial sector had pushed finance companies into increasingly higher risk categories.

Banks started to get into areas like leasing more aggressively taking away the best and least risky customers from finance and specialized companies.

"We found commercial banks getting into leasing," Fernando said.

"They had their own leasing companies. They had departments which went aggressively into leasing, because they found, among the leasing companies clientele, there were the cream of clients who were nearly coming to banks."

Commercial banks used to give lines of credit to finance and leasing companies for their business, but later it they were cut down, Fernando said.

"Lending by the banks to leasing and financing companies was restricted," he said.

The cost of funds of banks were less, which increased competition. Finance companies were then forced to advertise heavily for business, deposits, and also pay higher rates.

"These finance companies also left their traditional areas of business and go into areas of business that they thought would give them higher rates of return," he said.

Fernando said areas like real estate were an example. Unlike banks, however they had no 'parate execution' powers to quickly re-posses assets of defaulters.

Finance companies also gave credit to short-to-medium term, but the deposits were short term, of three to six months he said.

Though longer deposits running up to several years were taken, customers expected them to paid up almost on demand, Fernando said. This also exposed financed companies to a maturity mis-match.

Therefore they ran into liquidity in case there was a sudden demand from customers. Finance companies that gave loans for property had the worst mis-matches.


Some companies had dealt with the problem innovatively by negotiating stand-by credit from banks to meet unusual withdrawals.

Fernando said there seemed to have been irregularities in real estate transaction such inflating purchase prices and related company lending.

Fernando said there were weaknesses in applying fit-and-proper tests to directors of finance companies, and people who should never have been directors were in finance companies.

He said regulatory weaknesses had persisted for a long time and it was not a case of the current central bank officials or the current regime.

"This problem has come from so many years, so in fairness one must be clear that we are not referring to one individual or regime."

Fernando said firms that were not licensed were taking deposits. Though the usual answer was that what could be done when people deposit in unauthorized firms, he said that was not a sufficient answer.

"The very fact of giving a license was that without a license you should not be able to do that," Fernando said.

He said it would not do to say that if a person got into a car with an unlicensed driver no one was responsible.

"In the first place an unlicensed driver should not be allowed to get onto the road.
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While authorities said it was not possible to catch hundreds of people who took unlicensed deposits, Fernando said only a few needed to be taken in and dealt with to deter others.

At one time the Central Bank was taken to court by unauthorized deposit taking firm for asking questions.

Banks and finance companies usually get into trouble following collapses of credit bubbles, which are triggered by prolonged periods of low interest rates as happened in the US in 2009.

High inflation can be an early sign of impending banking troubles.

While a central bank which has policy rates can worsen a bubble by resisting higher interest rates in face of rising credit growth, credit bubbles have occurred even in the absence of central banking such in the 19th century banking panics in the US.

But the damage done in banking panics after the Fed was created such the Great Depression and Great Recession, have been greater.


Fernando said the Central Bank's current plans to consolidate and make bigger banks and finance companies were a good idea in principle, though there were questions over implementation and growth targets set.

"Having big banks and big finance companies and leasing companies is very good," he said. "There is no doubt. They can take shocks."

However he said some finance companies were doing well and forcing them to merge with others that were not well managed may not be a good idea.

It could be better to isolate bad companies and focus on them, he said.

There could be options like confining finance companies that were in a region and were doing well to continue with a restricted license, he said.

He said fit and proper tests must be strictly enforced.

Asking for higher levels of capital was also good, he said. Tools such as risk-based regulation could be considered, he said.

Already ratings had improved disclosure.

Fernando said there must be more efforts to educate depositors.

"We must educate the depositor," Fernando said. "I do not think the onus of having the safety of institutions should be placed on the regulator. We need a much more vigorous campaign to educate the depositor.

"A lasting solution would be to educate our public to distinguish between good and bad companies."

Update II

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